Steady Hands - Investment Outlook - March 2002

Marriott International and Host Marriott exhibited unexpected speed and nimbleness in responding to the tragedy of September 11. But neither has veered from an essentially conservative course.

By Staff -- HOTELS Magazine, 3/1/2002

Marriott International and Host Marriott emerged from the crucible of 2001 tougher than ever. Neither Marriott as a management company nor Host Marriott as an owner had the luxury of watching the September 11 terrorist attacks at arm’s length. It was their employees and two of their hotels at the center of tragedy. And, it was their unexpected speed and nimbleness in addressing the human, managerial and financial crises that gave Wall Street two more reasons to rank them as companies to watch for 2002-2003.

Marriott’s High Marks

With 13 sector-spanning brands and 2,600 operating units in 65 countries, iconic Bethesda, Maryland-based Marriott International seems too big and stratified to be fast afoot. Yet, within weeks of 9/11, Marriott pared US$400 million from its 2002 development budget. Ten percent of the projects under its sole control were dropped; another 40% were put on hold until the outlook is clarified. At the same time, the company began cutting overhead at the corporate, regional and unit levels to bring the cost base back to 1997-98 levels for the remainder of 2001.

Marriott instructed managers to provide “worst case” scenario plans to achieve profitability even if occupancy were sustained at 40%—fully 20 percentage points below the 60% usually considered as break even for upscale, city center hotels. Restaurants closed, energy costs were reduced and mid-level management was cut back severely. Small changes, such as adding tax onto drinks instead of building it into the price, generated millions of dollars in “found” revenue. The 20 to 30 years’ experience typical of a Marriott general manager paid off as gaps in operating margins began to close by mid-October.

Industry sources say multi-brand owners singled out Marriott “as having done a more effective job at cost cutting post 9/11 than franchisor peers.” Cost containment measures, complemented by aggressive marketing campaigns and face-to-face sales calls, enabled Marriott to hold house profit margins in its managed hotels to a four percentage point decline in the fourth quarter, despite a 25% drop in RevPAR. Fourth quarter diluted EPS came in at US$0.22, missing analysts’ US$0.25 estimates more because no timeshare notes were sold than because operations was not holding its own. The company ended fiscal 2001 with US$20 billion in systemwide sales, a diluted EPS of US$1.58 for full-year 2001 and “substantial operating profit,” according to J.W. Marriott, Jr., Marriott’s chairman and CEO. Not a bad pace for a giant.

“Marriott gets an ‘A’ for moving remarkably quickly to address the challenges of 2001,” says Lehman Brothers’ Joyce Minor. “It often defies its image as a big, bureaucratic, standard operating procedure-driven company. Marriott is one of the fastest to react to the changing environment, most recently in cutting costs and relaxing some hotel standards in light of the difficult operating conditions.”

Much of Marriott’s quick response to 9/11 and the ensuing economic nosedive can be credited to its early call on the downturn. Recognizing vulnerability in the technology sector (which accounted for a substantial number of room nights) and a soft economy, Marriott implemented containment measures and pulled back capital spending months before 9/11 launched a horrific fourth quarter for the travel industry. In August, it fortified its financial structure by renewing a corporate revolver that put maturity out five years. The company continued to divest real estate through 2001, bringing an additional US$663 million from asset sales into its corporate coffers and leaving it with only 10 owned hotels by year’s end.

Many hotel companies pursued similar strategies. What they did not do was rein in costs and maintain a solid gearing ratio while expanding by a record 313 hotels and timeshare resorts totaling 49,200 rooms. Marriott’s innovative approach to growth added US$5 billion-US$6 billion worth of properties to its system without requiring more than 10% equity on projects other than those viewed as vital to brand strength. Incentives such as higher guarantees for selected projects or help with finding financing kept Marriott’s debt in the US$2 billion-US$3 billion range, about half that of competitors with a larger real estate component in their models.

Ready And Waiting

Short-term RevPAR concerns aside, rough and tumble economies favor foursquare scions like Marriott International. The pioneering that Marriott has done in areas ranging from central and cluster reservations to revenue management and guest loyalty programs layers strength throughout the organization. This operational expertise combined with financial stability and brand strength in every sector positions Marriott to capitalize on the weaknesses of other companies and the nascent strengths in the international economy.

“We have the advantage in a weak environment. We are still paid our franchise fees and management fees,” says CFO Arne Sorenson. “We have no major debt maturities for several years. Our expenses are in line, so that when business normalizes—probably at 1998-99 levels—we should be well-positioned to drive profitability.”

Even with its capital clout, Marriott International is more likely to cherry pick opportunities than to embrace big-ticket consolidation. “Big acquisitions carry high risk,” says Marriott. “We have done some very good ones, and some that were not so great. We are not looking for the US$3-US$4 billion deals because we do not need a brand. That is why we did not step up on Meridien.” His preference is for small, strategic acquisitions and prime single asset deals. His aim is justifiable growth for distribution’s sake, particularly in Europe where the chain is, in his words, “under-represented.”

However, growth in Europe takes capital—far more than in Asia and the Middle East where wealthy individuals prefer to own hotels. Marriott devised an attractive joint venture deal to franchise Courtyard by Marriott in Germany. It also found ways to maximize what it brings to the table for strategic deals. “A certain part of growth depends on using the balance sheet,” says Marriott. “If you have a good balance sheet, you should use it to grow your business. But, it has to be optimized—through second mortgages, sliver equity and, in strategic cases, first mortgages.”

Michael Sullivan, head of HVS International’s hospitality investment banking division, says Marriott’s innovative leverage of “a pretty good balance sheet” to provide credit enhancement programs to owners helped the company grab market share during times of tight financing. “Marriott has substantially outpaced the development numbers of its competitors, especially in the luxury hotel end of the market,” says Sullivan. “Other hotels companies would do well to take a page from Marriott’s playbook and attempt to develop real, functional financial assistance programs that can offer hotel owners what they need.”

Host Performs Under Pressure

Moving equally quickly, Host Marriott was among the pacesetters for hotel real estate investment trusts (REITs) in its response to 9/11 and the downturn that followed. “First, we had to deal with the human issues,” says Christopher J. Nassetta, Host Marriott’s president and CEO. “We had people who died in the World Trade Center hotel. The hardest thing was moving past that to consider the physical issues and the impact on business.”

But, like the rest of the industry, Host Marriott had to focus on stabilization. Precluded from operating hotels as a REIT, Host assigned its 35-member asset management team to work “in partnership” with its operators to identify cost controls and reduce pressures on margins. “The aftermath of the attacks struck at the heart of our business: primarily city center hotels with a fly-in market,” says Nassetta. “We had to look at what that meant in terms of liquidity, debt covenants and operations. Our operators and asset managers found ways to lower the break-even levels of operations to 40%-50% occupancy. Fortunately, they did not have to drive that level too long.”

Corporate staff went to work on the financial side. Sale of the Vail Marriott and the Pittsburgh Marriott Center realized US$64 million. Proceeds are being used to repay existing bank debt and provide additional liquidity. A large bond deal also enhanced liquidity by nearly US$250 million. Covenants were reworked to accommodate the anticipated drop in EBITDA. Host paid off an existing credit facility, leaving no material debt maturities until 2005. In December, Host Marriott, the nation’s largest lodging REIT, announced it would suspend its stock dividend and reduce its cap ex program. The price of this quick action was somewhat higher debt and leverage but, says Nassetta, the upside is a financial position strong enough to weather a protracted recession or further terrorist incidents.

Nassetta took his message directly to shareholders. “Even if we did not have great news, we wanted to be visible and tell our shareholders what we were doing about the situation,” he says. A solid track record meant most of Host Marriott’s shareholder base remained in place. Investors willing to look past flat RevPAR projections for this year could see that the fundamentals would become very strong because, for the first time in a decade, supply growth will be under 2% in the upper upscale sector.

They could also see the inherent value of Host Marriott’s carefully constructed asset base, valued at US$9 billion. Sullivan refers to Host Marriott’s 122 upscale and luxury hotel portfolio as “simply the best hotel portfolio.” “Host Marriott is the gold standard. Theirs is the portfolio against which we measure every other hotel REIT. And, none compares,” says Sullivan.

The quality of the portfolio gives Host Marriott an important plus in this environment, says Bear, Stearns’ Jason Ader. Geographic diversity in markets with high barriers to entry, management by strong brands such as Marriott, Ritz-Carlton, Four Seasons, Hyatt, Swissôtel and Hilton and acquisition of “premier” assets gives Host Marriott “critical strength during this period of uncertainty,” according to Ader. “The combination of these traits has historically allowed Host’s portfolio to outperform those of its peers in terms of occupancy and RevPAR.” Ader adds that, by mid-January, Host’s senior notes had tightened to within 125 basis points of their pre-September 11 levels (after widening to 500 basis points immediately afterwards). The bonds may exhibit “modest volatility over the next several quarters.” “But, given the challenging operating environment, the company’s long-term outlook remains strong, in our view, with more than adequate asset protection and a very strong management team,” according to Ader.

Timing Its Next Move

Discipline gives Host Marriot another edge. Beyond buying back leases from lessees to simplify its structure, Host Marriott stayed on the sidelines of M&A activity since the end of 1998. “The opportunities just were not great,” says Nassetta. “Operational levels were at or near their all-time highs and we could not get yields that exceeded our cost of capital. Things started to slow in the fall of 2000. We went into 2001 focused on blocking and tackling, not acquiring.”

Nassetta sees more opportunities surfacing toward the end of this year. “Clearly, there will not be the volume of buying opportunities there was after the 1991 Gulf War/recession. But, over the next year, we will see some higher quality product coming to market—perhaps even some portfolios. We’re the logical candidate to consolidate at the 4- and 5-star level,” he says.

There will not be much movement by Host Marriott until the economy reaches an inflexion point and, even then, Nassetta “will not be a pioneer in terms of using cash.” Taking advantage of the REIT’s tax structure offers diverse avenues for deal making. In some cases, owners with tax issues may find it attractive to participate in operating partnership units that are convertible into shares. “We have to be incredibly disciplined about using operating partnership units or shares to get deals done. We have to look for ways to create value with our structure while maintaining a conservative stance,” Nassetta adds.

Nassetta’s goal is to position Host Marriott “as a player” so it can take advantage of opportunities that will create value as demand outstrips new supply over the next three to five years. The deciding factors in choosing deals will continue to be yield and cost of capital. Higher spreads may be just a logical outcome of post 9/11 deal making, but Host Marriott does not plan to change its basic strategy. Capitalizing on the opportunities of late 2002 and beyond will require both an opportunistic and strategic approach to deal making. “It would take the right metrics to get us involved in M&A activity again,” Nassetta says. “The next 12 to 24 months will be interesting.”